Consumption Tax: Prelude to a Recession in 2017?

By Anthony Fensom

Three consumption tax hikes; three recessions. By most accounts, that is a mean strike rate, but for businesses it could mean the next planned increase in Japan’s sales tax—in 2017—sparks another downturn in the nation’s economy.

Perhaps tired of being lumped in among the world’s most highly indebted governments, Japanese lawmakers agreed in March to a rise in the nation’s consumption tax rate from eight to 10 percent on April 1, 2017.

Unlike the previous legislation, this time there was no escape clause allowing for the increase to be reviewed “based on the comprehensive consideration of the economic environment.”

This was the get-out-of-jail-free clause used by Prime Minister Shinzo Abe in November 2014 to dump his predecessor’s policy amid a softening economy, helping him win re-election.

Yet with recessions following the three previous consumption tax rate hikes of 1989, 1997 and 2014, who would bet against another slump in 2017?

“As much as we economists always think that this time will be different, it’s clear empirically that, whenever they hike the VAT [value-added tax], it sparks a recession. It’s three out of three,” said Japan expert and economist Jesper Koll, formerly head of Japanese equity research at J. P. Morgan Securities Japan.

Koll was not alone among economists last year in predicting that the economy would shrug off the April 2014 sales tax rate hike, from five to eight percent. He said in March 2014 that it was “unlikely to derail the recovery” despite consumer spending accounting for around 60 percent of GDP, according to The Diplomat.

The economy surged at an annualized rate of 6.7 percent in the March quarter of 2014, as consumers and businesses stocked up on major items.

However, after April the economy fell off a cliff, contracting for two straight quarters—the technical definition of a recession—as shoppers closed their wallets.

While the economy bounced back in the following two quarters, posting an annualized 3.9 percent expansion in the March quarter of 2015, Minister of State for Economic and Fiscal Policy Akira Amari said overall sentiment still showed signs of a “deflationary mindset,” as reported by Reuters in May.

Fiscal credibility risk
On June 3, the Organisation for Economic Co-operation and Development (OECD) predicted—in its “OECD Economic Outlook” report—GDP growth for Japan of just 0.7 percent in 2015 and 1.4 percent the following year, amid a sluggish recovery in consumer spending and business investment.

Yet with general government gross debt at an estimated 230 percent of GDP (net debt is around 130 percent), the OECD warned Tokyo of a potential “loss of confidence in its fiscal credibility” should it fail to conceive a credible path toward improving government finances.

“Japan is not on track to achieve its target of a primary surplus . . . by 2020, even after the planned hike in the consumption tax rate to 10 percent in 2017,” the OECD report says.

“Even at 10 percent, the consumption tax will remain about half the average value-added tax rate in OECD countries. Additional tax revenue should come from broadening the personal and corporate income tax bases and increasing environmental taxes.”

Japan analyst Naomi Fink, CEO of Europacifa Consulting, agreed with the OECD report, saying Tokyo would be sending a dangerous signal to financial markets should it fail to proceed with the consumption tax hike.

“It’s not so much about the amount, as two percent is not going to make or break the government’s budget, but it’s the policy message they’re sending,” Fink says.

“Long term, we know what direction [the tax rate] is going to go in and that’s higher. The only thing that gives us a vision . . . is the government’s commitment—and if they don’t deliver, it heightens the risk of a fiscal crisis.”

Fink and Koll predict the consumption tax rate will continue rising, with Koll forecasting “somewhere between 12 and 20 percent in 10 to 15 years’ time.”

Koll says the tax system’s shift toward indirect taxation is the right approach given the demographics of the nation, which is experiencing a net population loss, but he proposes a different approach to soften the blow.

“My personal proposal for the coming 10 years, is that you increase the VAT by one percentage point every year at the start of April,” he says. “Politically, this would be very attractive, as the debate would then be [about] when we can take our foot off the brake, rather than when we step on it.”

Asset sales not taxes?
However, others have suggested a different approach: asset sales rather than tax hikes.

According to Kaetsu University economist Yoichi Takahashi, Japan’s government had debts of ¥1.1 quadrillion for fiscal 2013, but assets worth ¥652 trillion, putting Japan at the top of the league in government-controlled assets, The Japan Times reported in April.

Japan Post Holdings Co. Ltd.’s pending initial public offering, which could earn the government up to ¥2 trillion, could be the tip of a very large iceberg that includes other government assets such as Japan Tobacco Inc., in addition to valuable real estate holdings.

Hitoshi Suga, special advisor to the president, Tully’s Coffee Japan Co. Ltd. and a visiting professor at Akita International University, believes putting the burden on consumption tax would only worsen the situation for consumers and small businesses.

“Unlike in Europe and elsewhere, the Japanese consumption tax is applied to ordinary household items such as food and other essentials.

“Increasing it only puts the cost of reducing corporate tax onto the general public and small to midsized businesses, thereby worsening income disparities and preventing the Japanese economy from recording healthy growth,” he says.

However, according to PricewaterhouseCoopers (PwC), the Japanese government is considering a multiple rate system for the consumption tax from April 2017, with different rates applied to various products, although the details are yet to be confirmed.

If implemented, this would counter the current tax’s relative simplicity and efficiency given its limited exemptions, which are mainly for financial services.

However, he warned that the October 1 introduction of consumption tax on the purchase of cross-border digital services, such as movies or software, would require many foreign businesses to register and pay consumption tax for their offshore sales to Japanese consumers.

“Consumption tax and tax in general aren’t among the top five issues to be addressed for entrepreneurship and ventures to flourish here.

“There’s lots of low hanging fruit to be picked first, [including] rudimentary issues such as [a need to reform] bankruptcy law and [streamline] the ability to hire and fire, along with changing the education system and general perceptions of failure,” he says.

Similarly, entrepreneur Ko Nagata, managing director of Global Sky Group, says the business community is seeking further reform to encourage greater investment and growth, and “the consumption tax is certainly part of that mix.”

Will a consumption tax rate hike be a prelude to recession in Japan in 2017? If GDP growth reaches “escape velocity” at around two percent, aided by wage increases, the Abe administration could still avoid a recession. But if past experience is any guide, Japan should get ready for a rough ride ahead.